In our July issue, the article, “Hidden Pension Liabilities May Be Hidden for a Reason” received quite a bit of readership traction. This in turn prompted me to talk about another neglected area on a customer’s financial statement, Related Party Transactions (RPTs).
Credit professionals need to be cognizant of RPTs on a financial statement because these transactions can have a significant impact on a company’s financial health and creditworthiness. Understanding RPTs helps credit managers to not only evaluate the level of credit that can be extended, but also ascertain the impact the related party may have on the customer’s legal and operational viability. Here are a few reasons why credit managers should look closely at related parties and their respective transactions.
Risk Assessment: RPTs can sometimes be used to manipulate financial results or hide a company’s true financial position. For example, a company might engage in transactions with a related party to inflate revenues or understate liabilities.
Financial Health Evaluation: RPTs can affect a company’s profitability, cash flow, and overall financial stability. Credit managers need to consider these transactions to gain a comprehensive understanding of the company’s ability to meet its short-term obligations such as accounts payable, current taxes, short-term loans, intracompany debt, salaries, and lease payments.
Long Term Debt Repayment Capacity: If a company has significant RPTs, it may have obligations to related parties that could affect its ability to repay bank loans, intercompany debt, bonds, or other additional debt.
Conflict of Interest: RPTs may involve conflicts of interest, as the parties involved may prioritize their own interests over those of the company.
As is taught in almost every MBA program, Enron was formed as a natural gas pipeline company and ultimately transformed itself through diversification into a trading enterprise engaged in various forms of highly complex transactions. Among these were a series of unconventional and complicated related-party transactions in which members of Enron’s financial leadership held lucrative financial interests.
Disclosure Compliance: Transparent and accurate disclosure of related party transactions is vital for compliance with accounting standards and regulatory requirements. Credit professionals need to verify that their customer is following these rules. Undisclosed or misreported related party transactions can raise red flags and can ultimately impact credit decisions.
Auditor’s Opinion: The presence of significant RTPs may affect the auditor’s opinion on the company’s financial statements. If certain RTPs are not disclosed properly or fully, auditors may provide an unqualified opinion when a qualified opinion is more appropriate.
In summary, RPTs play a crucial role in understanding a company’s financial position and the risks associated with extending credit to them. Credit professionals should carefully examine such transactions to make informed credit decisions and mitigate potential risks to their own organization.
Your questions and comments are most welcome (nseiverd@cmiweb.com).
Nancy Seiverd, President, CMI Credit Mediators, Inc.
